Buying Rice Put Options to Profit from a Fall in Rice Prices

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Contents

Buying Rice Put Options to Profit from a Fall in Rice Prices

If you are bearish on rice, you can profit from a fall in rice price by buying (going long) rice put options.

Example: Long Rice Put Option

You observed that the near-month CBOT Rough Rice futures contract is trading at the price of USD 13.71 per hundredweight. A CBOT Rice put option with the same expiration month and a nearby strike price of USD 14.00 is being priced at USD 0.9100/cwt. Since each underlying CBOT Rough Rice futures contract represents 2,000 hundredweights of rice, the premium you need to pay to own the put option is USD 1,820.

Assuming that by option expiration day, the price of the underlying rice futures has fallen by 15% and is now trading at USD 11.65 per hundredweight. At this price, your put option is now in the money.

Gain from Put Option Exercise

By exercising your put option now, you get to assume a short position in the underlying rice futures at the strike price of USD 14.00. In other words, it also means that you get to sell 2,000 hundredweights of rice at USD 14.00/cwt on delivery day.

To take profit, you enter an offsetting long futures position in one contract of the underlying rice futures at the market price of USD 11.65 per hundredweight, resulting in a gain of USD 2.3500/cwt. Since each CBOT Rough Rice put option covers 2,000 hundredweights of rice, gain from the long put position is USD 4,700. Deducting the initial premium of USD 1,820 you paid to purchase the put option, your net profit from the long put strategy will come to USD 2,880.

Long Rice Put Option Strategy
Gain from Option Exercise = (Option Strike Price – Market Price of Underlying Futures) x Contract Size
= (USD 14.00/cwt – USD 11.65/cwt) x 2000 cwt
= USD 4,700
Investment = Initial Premium Paid
= USD 1,820
Net Profit = Gain from Option Exercise – Investment
= USD 4,700 – USD 1,820
= USD 2,880
Return on Investment = 158%

Sell-to-Close Put Option

In practice, there is often no need to exercise the put option to realise the profit. You can close out the position by selling the put option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the rice option sale will be equal to it’s intrinsic value.

Learn More About Rice Futures & Options Trading

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Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Choice!
    Free Trading Education!
    Free Demo Account!
    Big Sign-Up Bonus!

  • Binomo
    Binomo

    Good Choice For Experienced Traders!!!

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

How Falling Stock Prices Can Make You Rich

When buying stocks, falling market prices are your friend

Falling stock prices cause panic in some investors, but fluctuations in the market represent business as usual. Investors who are comfortable with this reality know how to respond to falling prices and how to recognize assets that are good buys when stock prices are dropping.

Ignoring Your Instincts

Human nature is to follow the crowd, and investors in the stock market are no different. If prices are going up, the kneejerk reaction might be to hurry up and buy before prices get too high. However, this often means that you’re rushing to buy a stock for, say, $50 today that you could have purchased for $45 yesterday. When thinking about it that way, the purchase seems less attractive.

The opposite also is true. If prices are falling, people often rush to get out before prices fall too far. Again, this might mean that you’re selling a stock for $45 that was valued at $50 yesterday. That’s no way to make money, either.

While specific events or circumstances can cause stocks to spike or plummet and force investors to take quick action, the more common reality is that day-to-day fluctuations—even the ones that seem extreme—are just part of longer trends.

If you’re in the market primarily to build your nest egg, the best course of action almost always is to do nothing and let the long-term growth take place. If you’re trying to quickly build the value of your business or your portfolio, though, seeing other people in a rush to sell a falling stock might be your cue to jump in against the current and buy. Consider how that can work for you. 

3 Ways to Make a Profit From Investing

When you buy a stock, you are purchasing a small portion of a company. Profit from such a purchase comes from three different sources:

  • Cash dividends and share repurchases. These represent a portion of the underlying profit that management has decided to return to the owners.
  • Growth in the underlying business operations, often facilitated by reinvesting earnings into capital expenditures or infusing debt or equity capital. 
  • Revaluation resulting in a change in the multiple Wall Street is willing to pay for every $1 in earnings. 

An Example

Imagine that you are the CEO and controlling shareholder of a community bank called Phantom Financial Group (PFG). You generate profits of $5 million per year, and the business is divided into 1.25 million shares of stock outstanding, entitling each of those shares to $4 of that profit ($5 million divided by 1.25 million shares is $4 earnings per share).

If the stock price for PFG is $60 per share, that results in a price-to-earnings ratio of 15. That is, for every $1 in profit, investors seem to be willing to pay $15 ($60 divided by $4 gives us a p/e ratio of 15). The inverse, known as the earnings yield, is 6.67% (take $1 and divide it by the p/e ratio of 15 to give us 6.67). In practical terms, you would earn 6.67% on your money before paying taxes on any dividends that you’d receive even if the business never grew.

Whether that return is attractive depends on the interest rate of a U.S. Treasury bond, which is considered the “risk-free” rate.     If the 30-year Treasury yields 6%, you’d be earning only 0.67% more income for a stock that has lots of risks versus a bond with virtually none.

However, PFG management is probably going to wake up every day and show up to the office to figure out how to grow profits. That $5 million in net income that your company generates each year might be used to expand operations by building new branches, purchasing rival banks, hiring more tellers to improve customer service, or running advertising on television.

If $2 million is reinvested in the business, that could raise profits by $400,000 so that next year, they would come in at $5.4 million—a growth rate of 8% for the company as a whole.

Another $1.5 million paid out as cash dividends would amount to $1.50 per share. So, if you owned 100 shares, for instance, you would receive $150 in the mail.

The remaining $1.5 million could be used to repurchase stock. Remember that there are 1.25 million shares of stock outstanding. If management goes to a specialty brokerage firm, buys back 25,000 shares of their own stock at $60 per share, and destroys it, the result is that now there are only 1.225 million shares of common stock outstanding. In other words, each remaining share now represents roughly 2% more ownership in the business than it did previously. So, next year, when profits are $5.4 million, they will only be divided up among 1.225 million shares making each one entitled to $4.41 in profit, a per-share increase of 10.25%. In other words, the actual profit for the owners on a per-share basis grew faster than the company’s profits as a whole because they are being split up among fewer investors.

If you had used your $1.50 per share in cash dividends to buy more stock, you could have theoretically increased your total share ownership position by around 2% if you did it through a low-cost dividend reinvestment program or a broker that didn’t charge for the service. That, combined with the 10.25% increase in earnings per share, would result in 12.25% growth annually on that underlying investment. When viewed next to a 6% Treasury yield, it’s a fantastic bargain.

Some Good News When the Stock Falls

However, what if the price of the stock falls from $60 to $40? Although you are sitting on a substantial loss of more than 33% of the value of your holdings, you’ll be better off in the long run for two reasons:

  • The reinvested dividends will buy more stock, increasing the percentage of the company you own. Also, the money for share repurchases will buy more stock, resulting in fewer shares outstanding. In other words, the further the stock price falls, the more ownership you can acquire through reinvested dividends and share repurchases.
  • You can use additional funds from the business, job, salary, wages, or other cash generators to buy more stock at a cheaper price. If you truly are focused on the long-term outlook, the short-term losses are less significant. 

A Few Persistent Risks

While most long-term stockholders don’t need to fear sudden dips, there are a few risks that can cause serious issues.

It’s possible that if the company gets too undervalued, a buyer might make a bid for the company and attempt to take it over, sometimes at a price lower than your original purchase price per share. This is essentially the same thinking that you may apply when you buy more shares during a dip, but since they’re doing it on a larger scale, they could push you out of the picture altogether.

If your personal balance sheet isn’t secure, you might suddenly find yourself needing cash. If you don’t have it on hand, you could be forced to sell shares at massive losses. You can avoid this scenario by not investing any money that could be needed in the next few years.

People overestimate their skills, talent, and temperament. You might not pick a great company because you don’t have the necessary accounting skills or knowledge of an industry to know which firms are attractive relative to their discounted future cash flows. If that’s the case, the stock may not recover from a sudden drop.

Buying (Going Long) Rice Futures to Profit from a Rise in Rice Prices

If you are bullish on rice, you can profit from a rise in rice price by taking up a long position in the rice futures market. You can do so by buying (going long) one or more rice futures contracts at a futures exchange.

Example: Long Rice Futures Trade

You decide to go long one near-month CBOT Rough Rice Futures contract at the price of USD 13.71 per hundredweight. Since each CBOT Rough Rice Futures contract represents 2000 hundredweights of rice, the value of the futures contract is USD 27,420. However, instead of paying the full value of the contract, you will only be required to deposit an initial margin of USD 2,430 to open the long futures position.

Assuming that a week later, the price of rice rises and correspondingly, the price of rice futures jumps to USD 15.08 per hundredweight. Each contract is now worth USD 30,162. So by selling your futures contract now, you can exit your long position in rice futures with a profit of USD 2,742.

Long Rice Futures Strategy: Buy LOW, Sell HIGH
BUY 2000 hundredweights of rice at USD 13.71/cwt USD 27,420
SELL 2000 hundredweights of rice at USD 15.08/cwt USD 30,162
Profit USD 2,742
Investment (Initial Margin) USD 2,430
Return on Investment 112.84%

Margin Requirements & Leverage

In the examples shown above, although rice prices have moved by only 10%, the ROI generated is 112.84%. This leverage is made possible by the relatively low margin (approximately 8.86%) required to control a large amount of rice represented by each contract.

Leverage is a double edged weapon. The above examples only depict positive scenarios whereby the market is favorable towards you. If the market turn against you, you will be required to top up your account to meet the margin requirements in order for your futures position to remain open.

Learn More About Rice Futures & Options Trading

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Choice!
    Free Trading Education!
    Free Demo Account!
    Big Sign-Up Bonus!

  • Binomo
    Binomo

    Good Choice For Experienced Traders!!!

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